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Rate of Return

Rate of return is the method of capital budgeting. This method is used to select a good investment project out of large number of investment projects. Under this method, we calculate rate of return. If we divide average net profit after depreciation and tax with the amount of investment and multiply with 100, then this will be rate of return and it will be compared with other projects’ rate of return. We only invest our money in that project whose rate of return will be high. If there is only one project, then we can compare its standard rate of return or minimum rate of return. This minimum rate is calculated by financial consultant after analyzing different investment.

We can calculate rate of return with following way:-

1st Way

Calculation of Average rate of return

2nd Way Average rate of return on average investment

In this way, firstly, we calculate average investment by dividing total investment by 2 because after dividing 2, the received average amount will equal to the amount which we can calculate after aggregating balance amount of investment after depreciation charging and then divided by number of years. So, it is easy to calculate just by dividing total investment by 2.

Now we can calculate average rate of return on average investment by following formula

For Example

Suppose, a company wants to buy $ 10 million machine and company can only invest in this project if minimum return on investment will receive 10 %. It is estimated that machine will give net profit after tax and depreciation $ 2 million. So rate of return is = 2/10 X 100 = 20% which is more than minimum return on investment. So, to invest in this project is profitable and company can accept this.

Rate of Return V/s Pay back period

Rate of return and pay back period are both traditional methods of capital budgeting in which we ignore the time value of money but rate of return method is better than pay back period because pay back period is the method in which Investor will accept only that project for the purpose of investment whose pay-back period is least out of different alternatives of projects. Other projects will be rejected. But overall profitability is not checked in this method. But rate of return method checks the overall profitability on the investment. We accept only that investment proposal whose rate of return is high and rate or return is also ROI. So, I think use of rate of return on investment is better for evaluation of investment proposals.

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